Fed’s Top Lawyer: Work Needed to Eliminate 'Too Big to Fail'

Federal Reserve General Counsel Scott Alvarez said “more work remains to be done” to curb the perception that the largest banks are too big to fail.

“The perception that some institutions are too big to fail reduces the incentives of shareholders, creditors, and counterparties of these firms to constrain excessive risk- taking,” the Fed attorney told the House Financial Services Subcommittee on Oversight and Investigations at a hearing Tuesday.

While the Dodd-Frank Act’s preamble says its intent is to “end ‘too big to fail,’” some of the largest banks may still benefit from the perception that they would be rescued by the government, Fed Chairman Ben S. Bernanke told lawmakers in February.

“We need to be working in the direction of eliminating it entirely,” Bernanke told the House Financial Services Committee on Feb. 27.

U.S. regulators and lawmakers are searching for ways beyond Dodd-Frank to limit the risk that a large bank failure will result in another taxpayer-funded bailout. Senate Republicans and Democrats are discussing new legislation that would boost capital standards, while Fed officials are discussing ways to limit the safety net and curb balance-sheet expansion at the largest banks.

Alvarez said in the text of his remarks that the Fed and the Federal Deposit Insurance Corp. are discussing the merits of a minimum long-term debt requirement for large banks that would help the FDIC fund the holding company of a failed firm.

Long-Term Debt

“Parent-level, long-term debt could lend greater confidence that the combination of equity owners and long-term debt holders would be sufficient to bear all losses at the consolidated firm,” Alvarez said in the text of his remarks.

Dallas Fed President Richard Fisher proposes that deposit insurance and the Fed’s discount window be limited to only banking units, and not extended to insurance or brokerage subsidiaries or the bank holding company.

Richmond Fed President Jeffrey Lacker said regulators need to help banks draft credible resolution plans, or living wills, showing they can be resolved through a bankruptcy process without temporary government support. One flaw in Dodd-Frank is that it has provisions for temporary government support, Lacker said in an April 9 speech in Richmond.

“The FDIC does have the ability to deviate in some important ways from what might occur under bankruptcy,” Lacker said. “In particular, it can make payments to creditors it deems ‘necessary,’ and it can draw on funds from the Treasury to do so.”

That provision “opens the door” for creditors to believe there is the possibility they could be bailed out leading them to “pay less attention to risk than they should.”